How should the government revive demand?

In the current economic slowdown, many claim that demand is the key issue that needs to be addressed. The important question that arises in this context is: If the finance minister (FM) decides to revive demand, how should she do it? Chairing the session on Founder’s Day lecture at the Institute of Economic Growth on 15 November, Naushad Forbes posed precisely this question to the august assembly of economists (See reference 1). 

In his short and valuable intervention, Mr Forbes elaborated on what the government could do if it decided that it could tolerate an extra fiscal deficit of Rs 1 trillion.  What is the best use of this fiscal space?  More investment in infrastructure? A cut in tax rates on personal income? This article is a simple-minded way of providing some possible answer.

The critical question is effectiveness of higher government expenditure versus that of equivalent tax that results in the same additional fiscal deficit (deficit henceforth) of Rs  1 trillion. So, compare two situations: In the first, the government keeps the tax rate constant, increases government expenditure by an amount such that the deficit is higher than what it was by exactly Rs 1 trillion.  In the second, the government keeps its expenditure constant, decreases the tax rate exactly by an amount such that the deficit is higher than what it was by exactly Rs 1 trillion.  

Without losing the crux of the argument, let us disregard foreign trade and consider an economy with gross domestic product (GDP) of Rs 300 trillion.  Taxes are at a flat rate of 20 per cent and people consume 75 per cent of their disposable post-tax income.  Tax revenue is Rs 60 trillion, post-tax income is Rs 240 (=300 less 60) trillion, and private consumption of Rs 180 trillion is 75 per cent of such income.  The three components of aggregate demand, namely private consumption, private gross investment and government expenditure are Rs 180 trillion,  Rs 55 trillion, and Rs 65 trillion, respectively, and they add up to aggregate supply, namely GDP.  Government expenditure at Rs 65 trillion exceeds tax collection by Rs 5 trillion, which is the deficit.

Now, with the tax rate unchanged, increasing government expenditure by only Rs 1 trillion will not expand the deficit from Rs 5 trillion to Rs 6 trillion.  Incremental tax revenue from the extra income that such additional expenditure generates will contain the increase in deficit below Rs 1 trillion. Government expenditure will have to be ramped up by Rs 2 trillion — from Rs 65 trillion to Rs 67 trillion.  When the system settles down, the deficit will be up from Rs 5 trillion to Rs 6 trillion.  In the new configuration, GDP will be Rs 305 trillion, tax revenue Rs 61 trillion (20 per cent of 305), private consumption Rs 183 trillion (80 per cent of 305 – 61) ) and fiscal deficit  Rs 6 trillion (= 67 - 61). 

What happens when, with government expenditure unchanged at Rs 65 trillion, the FM decides to reduce the tax rate, mobilise less revenue and let the deficit widen by Rs 1 trillion?  Leaving government expenditure unchanged, reducing the tax rate marginally from 20 per cent to 19.47 per cent, that is by 0.53 percentage points, will result in the deficit widening by Rs 1 trillion to Rs 6 trillion and GDP increasing from Rs 300 trillion to Rs 303 trillion. 

Note that with GDP unchanged at Rs 300 trillion, a 0.53 percentage point reduction in the tax rate would reduce tax revenue (from Rs 60 trillion to Rs 58.4 trillion) and increase fiscal deficit by Rs 1.6 trillion. But, GDP does not remain unchanged.  With more disposable income for the same GDP, people consume more, and both GDP and tax revenue increase. The system settles down when GDP is Rs 303 trillion. So, with an increase in deficit of Rs 1 trillion driven by reduction in taxes increasing GDP by only Rs 3 trillion, compared to the increase of  Rs 5 trillion under the expenditure-led strategy, the preferred route for stimulating demand and output is an increase in government expenditure rather than a reduction in taxes. 

The above argumentation neglects the supply-side responses that a reduction in taxes may elicit by changing the labour-leisure choice of people. But, the impact of such changes is likely to be minimal in an economy with considerable unemployment. In the short run, over the next few quarters, clearly, deficit-financed expenditure rather than reduction in taxes is the way forward. 

Mr Forbes also asked whether such expenditure should be on physical or social infrastructure, or on paying up the unpaid bills of the government. Admittedly, social infrastructure such as education and health is at least as important as physical infrastructure, such as roads and safe water supply. But, given the questions on appropriateness of delivery design and efficiency of implementation of social expenditure, and their appropriate evaluation, the balance of arguments seems to favour expenditure on physical rather than social infrastructure.

A cash-based accounting system tends to artificially understate the true fiscal deficit. So, what about clearing the unpaid bills, such as to the Food Corporation of India, rather than spending on new items? This is a tricky question. Payment arrears on government account, which sets off a chain effect and undermine the payment culture and financial discipline, should be scrupulously avoided.  However, in an extraordinary situation with the need for reviving demand, it may be better to spend on new items rather than clearing arrears. After all, many households and firms holding unpaid claims on the government may have made some arrangements to tide over their cash flow problem.  In the first round at least, such creditors may not spend as much of the extra cash that they receive in the process of arrears clearance as a producer or consumer receiving fresh money.  

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